Home-builder stocks are beaten down, but analysts are super-bullish on ‘super-affordable’

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Contractors raise framed walls while working on a townhouse under construction in San Jose, California. The Commerce Department will release August new-home sales figures Wednesday.

It’s hard out there for the home builders.

In late July, D.R. Horton, Inc. DHI, -1.11%  , announced third-quarter results that beat estimates, and offered stronger guidance for the coming quarters. Net income, sales orders, and home closings were all higher by double digits, management said, citing a set of market conditions that could only be described as a housing sweet spot: “healthy market conditions across most of our markets with solid demand… and the supply of new homes remains limited.”

Horton’s stock jumped about 10% from a short-term low and drifted upwards over the coming weeks. But then it started falling again, and most recently has been trading just a bit higher than before those earnings. Shares have lost more than 17% in the year to date, even as most analysts surveyed by FactSet rate the stock a buy.

What gives?

Equity analysts cite a litany for headwinds faced by homebuilders – some of them fundamentals that are hitting their business, and others that may not matter to the bottom line, but keep investors wary of the stocks. “You have market sentiment that believes that interest rates are going to significantly derail demand based on affordability,” said Peter Martin, an analyst with JMP Securities. “Portfolio managers are saying, I’m not going to fight the Fed.”

Read: We’re probably at peak housing. Here’s what that means.

Even though buyer enthusiasm for new homes has waned a bit, it’s not actual affordability that’s hurting, said Carl Reichardt, an analyst with BTIG. “It’s more psychological. Buyers have been resisting price increases which have been aggressive across the board. Part of it has been materials prices: builders have had to pass on higher pricing.”

Builder stocks were pricey going into the new year, Reichardt pointed out, and then some momentum waned along with traffic in the spring. “Since that time, more data has emerged that business has slowed,” Reichardt told MarketWatch.

Other analysts, meanwhile, take a big-picture view.

“Notably, investor sentiment towards both sectors remains highly challenged, with concerns regarding interest rates amid a Fed rate hike cycle as well as the broader cycle continuing to impact the builders, while cyclical concerns, input cost inflation and more recently currency have acted as headwinds against the building products companies,” wrote J.P.Morgan analysts recently. “Builder fundamentals remain steady and solid,” they added, noting that they had upped estimates since the beginning of the year.

For now, analysts are uniform on one idea. The real sweet spot for homebuilders is what Reichardt calls the “super-affordable” segment of the market. Right now that’s dominated by LGI Homes, Inc. LGIH, -0.44%  and D.R. Horton, though Reichardt also notes that NVR Inc. NVR, -0.12%   and Meritage Homes Corp. MTH, -2.55%  have both started to move in that direction. The J.P.Morgan analysts agree with that assessment of Meritage Homes.

LGI’s average selling price is expected to be between $220,000 and $230,000 this year, versus the national median of $328,700. Reichart defines super-affordable as one that is in the bottom quartile for new homes for the county in question.

For some sense on how the investor view is diverging from the fundamental demand for entry-level homes, LGI Homes shares are among those that have taken the biggest beating this year: down more than 33% since the start of the year, even as analysts like Martin are bullish: He offers a price target of $84, a 68% premium over Monday trading levels.

The builders who have specialized in “super-affordable” homes are finding ways to keep their margins strong, Reichardt noted. “The nice thing about super-affordable is that it’s easier to construct, and you have minimal changes so it’s the same model consistently.”

As for other builders catching up to the industry leaders, Martin calls it a process akin to “moving a Disney cruise ship in your bathtub.” It takes years for builders to scout land, research the local market, prep the infrastructure, and so on.

Reichardt knows that many builders were scarred by the bubble of the last decade. Far too many were left with land in the “drive-until-you-qualify” hinterlands. But he still thinks the companies that aren’t at least moving in the affordable direction will regret it.

“If you as a builder believe that the wave of first-time buyers represented by millennials is likely to come back to the market over a long period of time, that the existing housing market is short of affordable product, that blue-collar boomers and retirees need affordable move-down homes, and that we have been underbuilding homes in the downturn, in the long view it makes a lot of sense to be in these markets because that’s where they can afford this house,” he said.

Also see: Help wanted: Home builders need women, immigrants and robots to fill shortage